There goes the neighbourhood

It’s open season on hedge-fund managers and high-frequency traders in Europe and the USA. Legislators on both sides of the pond are voting on new rules to redefine the traditional relationship between risk and reward – expect a legalese version of: don’t take the risks because we’re going to deny you the rewards. Much of this is necessary work – after all, we don’t want those naughty defaulting mid-western mortgage holders bringing down the financial system again, do we? But some of it looks more like political grandstanding than enlightened policy-making, and some of it seems downright unhelpful. Automated Trader’s Editor, William Essex, considers the possible unintended consequences of the current transatlantic regulation-fest, and wonders whether we might all be better turning up for work – somewhere else.

We'll get to the latest US developments in a couple of pages'
time. Before that, here are the first two paragraphs, complete
and unabridged, of a recent formal public statement from the
UK-based Alternative Investment Management Association (AIMA).
The context is obvious.

"AIMA, as the global hedge fund association, fully supports the
regulatory goals of the EU's Alternative Investment Fund Managers
[AIFM] Directive. It is desirable both to increase transparency
and to improve systemic risk assessment in the interests of
financial stability.

"However, we are concerned that many of the proposals in the
texts of the Directive discussed by the European Parliament's
Economic and Monetary Affairs Committee (ECON) and European
finance ministers at the ECOFIN meeting are impractical and
unworkable."

Bam! AIMA has gained a reputation, over the years, for being
broadly in favour of just about everything from motherhood right
through hedge-fund regulation and all the way to apple pie. The
Association typically puts out a supportive little press release,
sometimes only a sentence long, whenever an influential public
figure so much as mentions alternative investment or hedge funds.

We used to think this was mildly amusing. We don't any more. We
think it's a deliberate and very clever strategy to keeping
powder dry until it's really needed. In raising an issue of
public concern like this one, AIMA doesn't complain and can't be
dismissed as one of the 'usual suspects'; this criticism comes
from, well, a friendly voice. Even the team of redundant
ex-Kremlin watchers we keep in the back office noticed that word
"unworkable". Even they think something's up.

You can find the whole of the announcement at www.aima.org, so
we'll try very hard to limit ourselves to just one or two
sentences from the rest of it. Try this for size.

"In particular, it seems that the process of negotiation in ECON
was so highly politicised that it took little note of the legal
and practical feasibility of the compromise amendments put
forward. For example, Article 35a now prohibits investors from
investing in third country funds unless the jurisdiction of the
fund meets a list of various conditions which have very little to
do with prudential regulation. It is questionable whether, today,
every EU Member State would meet those conditions."

Ha!

"We are also concerned that the Directive singles out our
industry for special treatment and imposes controls and burdens
that it does not place on other financial market participants."

Yes!

Andrew Baker

"Many requirements proposed to be put on the alternative asset
managers in the ECON text are disproportionate to the point of
being punitive. Often, they are considerably more onerous than
obligations imposed on the rest of the financial services
industry."

If you have any vuvuzelas left over from the World Cup, prepare
to play them now.

"All we are seeking is equal and fair treatment."

Cue vuvuzelas!

Go AIMA!

And by the way, this is not just some ill-judged release put out
by some disgruntled ex-hack of a press attache returning to the
office after an even-worse-than-usually disastrous excursion to
the dentist. This is a formal statement made by Andrew Baker, who
is the CEO of AIMA.

It covers a lot of ground, you might say.

Trisagreements and triscussion points

Moving swiftly on, here's Baker on what might happen if the AIFM
Directive ever got passed into law. Baker says: "We have already
heard how the Directive would hit small firms across Europe and
make it more difficult for new businesses to be created, and how
development banks investing in emerging markets would be
affected. Real estate and infrastructure investment in Europe
would also be impacted because funds in this sector would also be
covered by the Directive. We're talking about schools, hospitals,
shopping centres, things that affect ordinary EU citizens."

It would be kind of bad, right?

So, given that everything quoted so far was said in May, here's
what actually happened next. It would be funny if it wasn't
tragic.

Baker spoke (that last paragraph) on 14th May. On 17th and 18th
May, in separate votes, the European Parliament and the Council
of Ministers voted in favour of adopting the AIFM Directive. But,
because they couldn't agree on the wording for a final version of
the thing, they each voted to adopt their own variant on the AIFM
Directive. That means there are two versions now chugging their
way through the legislative process. That's two mutually
contradictory directives. If you're complying with [one version
of] the directive, you're likely to be in breach of [the other
version of] the directive. Have you ever wondered what Catches
One to Twenty-one were all about? Try Europe.

As you might not be surprised to discover, there is an
established europrocedure, with its own eurobureaucratic
infrastructure, for resolving eurodilemmas of this nature. The
next stage (and this was all written down somewhere by
sober-faced Europeans who believed in what they were doing) is to
take the two versions of the one directive through a "trialogue"
process (from dialogue to trialogue, geddit?) involving the
people who voted for one version, the Parliament, plus the people
who voted for the other version, the Council, in discussion with
the European Commission, who notionally don't know anything about
it - yet. The task of the triologists is to arrive at a "final,
definitive text" (don't let your colleagues hear you giggle as
you read this) that is "acceptable to all parties" to the
discussion - sorry, triscussion.

And the punchline of the whole story (this is being written in
the first week of July) is that the AIFM Directive is scheduled
to be adopted formally into the EU legal system in mid-July;
that's just around about the time you read this magazine. If you
happen to be reading this in Brussels or another eurocapital,
those parades outside your office window are celebrating the
triscussion participants' unanimous vote in favour of the final,
single, indivisible, definitive AIFM Directive. Switch on the
news channels. It's there at the top of the hour.

Those naked shorts

No space, sadly, to acknowledge that even a final, definitive
text of a Directive doesn't get to be EU law until it has been
debated and voted into national law by the parliaments of each of
the EU's twenty-seven member states. Yes, that's twenty-seven
separate parliamentary debates before this - shall we call it
federal? - law can be admitted into the legal systems of the
twenty-seven member states of the, ah, union. (There's a
precedent here somewhere … can't quite think what it is.)

But we can't leave this subject without a quick mention of German
Chancellor Angela Merkel and her late-May ban on naked short
selling of euro-government bonds, leading shares, et cetera, in
Germany. "The euro is in danger!" said Merkel, raising high the
Stars and, er, Blue Background. Mike Hamm, managing director of
Fernbach, sets the scene. Hamm says: "Germany's move against
short sellers caught the financial markets somewhat by surprise.
In light of the recent indecisiveness of the German authorities
how to deal with the euro crisis and the debt problems in Greece,
few were expecting the German government and the regulator BAFIN
to set overnight new regulations without the usual lengthy
internal and external deliberations."

Note in passing the - perhaps unintentional - implication that
while you can factor in "the usual lengthy …
deliberations", it is more problematic to factor in the
likelihood of a politician taking swift action. Merkel's move was
popular. Hamm says: "There is certainly political pressure on the
Chancellor to demonstrate leadership in tackling the financial
crisis. In Germany there is a growing perception within the
public but also within the main political parties that financial
speculators have brought havoc to the EU." In case you're
wondering (and to adapt the name of a popular toy store),
financial speculators are us. Hamm adds: "Many equate all
alternative investment constituents such as short sellers, high
frequency traders, hedge funds or venture capital firms as the
main culprits. The discussion of the current economic situation
is very emotional and often lacks a rational, differentiated
assessment of the factual causes and consequences."

Mmm. The next move was a call from Merkel and French President
Nicolas Sarkozy (who didn't ban anything) for EU-wide action on
"certain financial techniques and the use of certain derivative
products, as, for example, short selling and credit default
swaps".

That'll help.

We'll slide politely past the memory that the immediate
consequence of Merkel's original ban was a Europe-wide market
crash. We won't get into the terminology of the debate over
whether a ban on short sales, naked or otherwise, is a bad or a
disastrous or a pointless thing - terms such as "politically
motivated" won't appear in the article, and unlike some people,
we won't use the word "dithering" to describe the twenty-seven EU
governments' reaction to the Merkel/Sarkozy call to action (sic).
That's all been said and done. With a respectful nod to George
Soros and his colleagues across the FX industry, we will first
concede that, yes, this does seem really to be an attempt to ban
market volatility, and secondly, that yes, this does look awfully
like a German/French government initiative to take on the FX
markets.

But we've been there before too, so forget unintended
consequences (thanks for the volatility, ma'am), and let's talk
about what's really going on here.

Capital requirements, anyone?

Nobody panic! We knew this was coming. The latest package of
amendments to the EU's Capital Requirements Directive (CRD)
include a stipulation that bonuses to hedge-fund managers
across the EU should be regulated - which means, limited to a
fixed proportion of base salary and not actually paid until
several years after they have been awarded. Nothing actually
happens until 2011 at the earliest, and, this being the EU,
there's a lot more voting and debate to come before the new
improved bonus-lite CRD gets implemented across the
twenty-seven EU member states.

But the thing is consistent with the rest of the regulatory
jigsaw now being glued firmly into place on top of Europe's
trading infrastructure. There's a reasonable chance that
they're actually goint to do it.In the 'Most Relaxed Response'
category, the award goes to this [nameless by agreement]
hedge-fund manager. "What do I think of it? It's unworkable.
Why do I think that? Because I like the idea of living in
Zurich."

Would the last star-performing hedge-fund manager to leave the
West End of London kindly switch off the British economy? Thank
you.

Unenlightened self-interest?

It isn't logic. It isn't common sense. It isn't - for us - just a
matter of shaking them warmly by the throat and getting them to
see sense. It's the politicisation of regulation and the picking
of soundbite-sized targets. The hedge-fund manager who began an
interview for this feature with the words, "They're all idiots!"
and ended it with, "So like I said, they're all complete idiots!"
was speaking off the record, strictly on background, so we can't
attach a name to the quote. But actually - they're not.

If you're going for the votes of an electorate in which the
over-emotional non-financiers outnumber the financiers by a
factor of lots and lots, and if you're speaking in the aftermath
of - yes, the crash, but more importantly, the bail-out of the
banks (which, as you know only too well, played badly in
political terms), AND if your concept of a long-term view matches
the time between now and the next election, you're acting
entirely sensibly if you choose to (excuse the technical language
here) bash an easy target.

Without meaning this as a criticism, it might be reasonable to
suggest that the finance industry - and in particular, those of
us who know how to fine-tune an algorithm - have reached a point
at which we are - no, really - too clever for our own good.
Organisations such as AIMA may be putting our case, but these are
populist times. Political short-termists motivated by rational
self-interest don't have the time to consider sophisticated
long-term arguments about the benefits of a healthy finance
industry, after all.

Consider some of the media/political rhetoric highlighted by
David Dungay in his piece 'Flash ban wallop!' in the Q4 2009
issue (see www.automatedtrader.net). Consider some more recent
political output. Arlene McCarthy, the MEP responsible for
steering the Capital Requirements Directive (yes, another
directive; see the box 'Capital requirements, anyone?') through
the European Parliament, said of her charge: "This EU-wide law
will . . . end incentives for
excessive risk-taking."

How? It limits hedge-fund managers' bonuses. Stop taking those
risks because they're not going to let you take the reward. The
European Union's Internal Market Commissioner, Michel Barnier,
backed up McCarthy with the observation that: "This is a step in
the right direction." Ending incentives, he means. And here are
two more facts to rub together: first, the UK hosts some 80% of
Europe's hedge-fund industry; secondly, when George Osborne, UK
Chancellor of the Exchequer, failed in an attempt to block the
hedge-fund bonus ban, his comment was that he found "not many
allies" in those discussions.

It probably would be rocket science if we started from here and
extrapolated all the way to the conclusion that eurodiscussions
are never weighted towards the member states with the most "skin
in the game". But it's also obviously true. Crudely, the member
states whose economies would be least affected by thumping our
kind of finance - they're the ones who think knocking down an
industry that isn't even on their turf is going to fix their
problems. With their electorates, maybe. In the short term.

Civilisation as we knew it

It's at this point in the writing of a long feature that started
out reviewing reaction to proposed and actual new regulation, but
somewhere along the way turned into a jeremiad with an underlying
theme in the neighbourhood of "They're coming to get you!", that
the urge to call up Richard Balarkas and find out what he thinks
becomes irresistible.

For Balarkas, CEO of Instinet, what we're seeing here could be a
historic reversal. Balarkas says: "Equity markets have been
through an enormous process of democratisation since the
mid-eighties. By that, I mean the removal of inefficient
structures, monopolies, privileged positions. The markets we have
today are so different; they're typified by buyer power." Yes,
you have to go through the whole compliance thing, but there's no
sense of having to join any kind of privileged club. Balarkas
continues: "Top of the evolutionary tree are very smart people
using their own money, who can trade very cheaply -
high-frequency traders exercising enormous buyer power."

It's a bit like flying, in a way, and international flying in
particular. Whereas once the phrase 'jet set' actually meant
something, today - it doesn't. Top of the evolutionary tree are
people who can buy first/business-class air travel without
thinking about it, but we can all fly. Balarkas says: "What I'm
scared about is that we're seeing that stall. It would appear
that there are plenty of regulators, and possibly more
politicians, who seem inclined to tar every aspect of the
financial industry with responsibility for the financial crisis
that was essentially triggered by sub-prime debt in the US and
the inappropriate selling of complex derivative instruments."

Check in three hours early, open your baggage, turn on your
laptop, take off your shoes, stand in front of this x-ray
machine, can't take those cosmetics in your hand luggage - we can
all nip across the Atlantic for shopping, dinner, a show and then
overnight in New York or London. The flight/finance analogy works
best at the point where you start shouting: "What did we do to
deserve this treatment?" Balarkas says: "My overall fear is that
the knee-jerk reactions of politicians, and the lack of a
coherent and transparent process for evaluating, discussing and
debating issues of market structure with regulators, will make
the process of democratisation stall, if not actually go into
reverse."

To describe market development in terms of democracy is to
remember that people are involved - and jobs, employment,
careers. If politicians can find political capital in labelling
trading a 'bad thing', it's a fair projection that pension funds,
institutions, even schools and hospitals might be hit, but
there's an even more immediate impact on the people actually
generating the wealth. If these highly intelligent, creative,
internationally mobile wealth creators can't dream up a way of no
longer being there when the axe falls.

But before we look to the future, let's go queue at the
metaphorical airport for a few long but mercifully metaphorical
hours, and then skip across the water for a quich look at what's
happening in the US of A.

Leaving the casino?

If this was Hollywood, we would now pause for plot exposition:
the two leading characters would deliver dialogue in which they
explain to each other what the situation is, and what they're
doing about it. But this is Washington, so we're dealing with a
cast of leading characters, from politics and the US media, large
enough to fill, well, the Hollywood Bowl. And to judge from
recent media coverage, they've all brought their own megaphones
to the dia- sorry, tria- sorry, multilogue. The financial
regulation bill now moving through the US legislative system is a
decisive step towards the imposition of tough controls and curbs
on the activities of banks, hedge funds, derivatives traders and
others, but it's also a compromise.

The 'American way of regulation' is not exactly bureaucratic in
the European sense, but it is comprehensive and all-encompassing
in the distinctly US sense that all interested parties -
including lobby groups - tend to have an influence on the
outcome. Thus, the Volcker Rule, whereby banks have to spin off
proprietary trading operations (and desist from 'casino banking')
if they want to continue as plain-vanilla deposit-takers, has
been adjusted to allow said banks to keep partial ownership of
those spun-off subsidiaries. They're still in the game.

Among other highlights: OTC derivatives would be brought onto
exchanges except where they were being used to hedge risk by
non-financial companies (a return to the early days of the
derivatives markets, almost); there'll be a new oversight body to
impose higher capital and liquidity requirements on 'systemically
significant' enterprises; and there'll be a levy on big financial
players to cover the cost of setting up and running that and
other new regulatory bodies that the new bill stipulates. There
will also be lots of studies into the feasibility of heavier and
more pervasive regulation in other areas of finance. Good thing
we don't allow terms like 'buck-passing' in this magazine.

Lots of work for lots of regulators; lots of staff to recruit;
still lots of negotiating to be done before the whole apparatus
beds down into a coherent framework for financial activity. US
financial stock prices rose on US markets as the bill's
(relatively) final form became clear, and Bob Froehlich, senior
managing director at Hartford Financial Services, was quoted as
saying: "Two years later, people will look back and say 'My gosh,
nothing really changed.'" Only a cynic would celebrate this great
triumph by setting out to find loopholes in, for example, the
'divest but continue partially to own' provision applicable to
'casino banking' practitioners, and of course there's a clear
distinction between a derivatives trade to hedge financial
exposure and a derivatives trade to hedge a price move in a
mission-critical commodity. Isn't there?

But these 2,000 pages of closely debated legislative drafting are
still vulnerable to negotiation and change. One comment that is
seldom made about the US approach to legislative change is that,
although it tends to appear on the horizon like a stampede of
grandstanding politicians making the most of their opportunities
in the TV lights, in fact it typically arrives as a series of
incremental steps towards a very small change. Sounds big,
delivers small. Sounds iconoclastic, delivers a slight nudge to
the status quo. The reason for that is the existence of a lobby
group for every side of the argument (except, perhaps, the
defaulting midwestern mortgage holders). There is, as you might
say, balance.

And that would be fine if balance equated to certainty. We could
all get on with the job free of any worry that those feasibility
studies will turn against us; free of any worry that if we don't
tie ourselves up in lobbying, rival lobby groups might turn
against us; free of the worry that our elected leaders will be
more concerned with the electorate than the health of the
financial sector; free of - you get the idea. The next US
presidential election is scheduled for November 2012, just ahead
of the end of the world. [We covered those Mayan prophecies about
what's coming up in December 2012 in Peek Ahead a while back; see
also Wikipedia and Roland Emmerich's film 2012.] These next
couple of years won't be a time for decisive table-banging.

NYSE Technologies and Markit work together to promote European
market transparency

NYSE Technologies and Markit have launched a joint initiative
to consolidate data and enhance transparency in the European
OTC equity markets. From now on, NYSE Technologies will
integrate data from Markit BOAT within its own range of market
data products.

Mark Schaedel, Senior Vice President, Global Data Products,
NYSE Technologies, tells us: "This will give joint users access
to trade reports on an average of roughly EUR 30 billion of OTC
trades in equities every day which is equivalent to
approximately 80% of the daily volumes traded on all European
equity markets through April 2010. We are very excited to be
working toward a seamless, market-wide OTC data solution with
Markit to improve the quality of market data across Europe's
cash equity markets."

The initiative is open to other publication venues in Europe in
order to give market participants access to the most
comprehensive dataset on the European OTC equity markets from a
single source. The new service will include deployed data
feeds, hosted and managed solutions, web services and
historical products. NYSE Technologies will also integrate data
from Markit BOAT and other data providers into packaged
solutions which provide customers with a single view of
activity across all major European cash equity markets.

It's not over until the fat-tailed shaggy dog barks

So the grizzled, maverick veteran says to his rookie partner: "In
Europe, the risk is that politically motivated pressure will slow
down the industry as a whole, and possibly even reverse the
democratisation of markets. Heck, we'll end up with enforced
low-frequency trading."

And his rookie partner says: "Yeah, and in the US, the risk is
that we'll be living with uncertainty right through the election
and beyond. Some kinds of uncertainty are good for business, but
you can't plan a strategy for the long term if you can't be sure
you won't end up saddled with a whole extra weight of new
regulation."

The grizzled maverick veteran mutters something under his breath
about hiring a better scriptwriter and/or dialogue coach, and
then fires up the battered old cop car they brought to the
stake-out. As they clatter off into the sunset and the credits
roll, we turn our attention back to AIMA. Here's AIMA's Chairman,
Todd Groome, with his views on US financial reform. Groome says,
first: "Our industry did not cause the crisis, and was as
negatively impacted as any sector. Nevertheless, as a mature
industry, representing investment managers and other
professionals throughout this global industry, we have acted to
support improvements in our regulatory framework and in financial
stability."

Not our fault, but we're on board. Groome continues: "The
agreement by US legislators on financial reform, the Dodd-Frank
Bill, is a very significant step in the evolving and broader
international regulatory framework. This is a landmark piece of
legislation that, once passed, will represent an important part
of the global system of supervision for the financial services
industry." And hedge funds are a good thing too. Groome says:
"The diversity of our industry's activities serves to reduce
pro-cyclicality in financial markets, and thereby supports
financial stability. Through a more informed supervisory
relationship, we expect supervisors and other public authorities
to obtain a better understanding of our industry, as we
contribute to their efforts to identify market stresses and
vulnerabilities."

Let's cut to the 'But'. Groome says: "This bill would tax larger
US hedge fund managers to finance the estimated costs of this
legislation, despite the fact that no hedge fund received public
funds or caused any financial stress to a banking institution or
other counterparty during the crisis. The inclusion of hedge
funds in this financial tax suggests that our industry has been
singled out for more onerous treatment. If this tax is targeted
at perceived wrongdoers or those who caused the crisis, hedge
funds had nothing to do with the cause of the crisis, and there
has been no finding before, during or since the crisis that hedge
funds cause increased risk to financial stability."

Which is where we began. The 'known unknown' in all this
imbroglio is this: the various hedge funds and other financial
entities that are being singled out don't have to be based where
they are today. There are claims that 'bashing' hedge funds will
damage the wider community. That's because the hedge funds might
leave. You can find mention of India, Brazil, Switzerland,
various parts of Asia in this issue, and although this article
isn't just an unusually long-winded way of referring you to Andy
Webb's piece on SGX (page 32), the fact is that we do find
ourselves frequently talking to non-EU, nonUS exchanges (and
other less high-profile bodies) where the key message is how keen
they are to attract business.

Wolfgang Fabisch says: "Wrong regulation would cause a tendency
to leave a jurisdiction. The distinction is between wrong and
right, rather than heavy and light." Good point. How right was
the ban on shorts? How wrong is your remuneration package?